CVS: Will Its Growth Elixir Work?

It's closing in on Walgreen, but the race is getting tougher

Sitting in the back office of a new CVS Corp. (CVS ) drugstore in Chicago, Hanley H. Wheeler III opens a folder to reveal pages that rival Walgreen Co. (WAG ) would love to see. Highlighted are the addresses of 20 outlets CVS will open in Chicago this year. Scores of other addresses represent CVS's wish list of possible new sites in its assault on the heart of Walgreen, based in Deerfield, Ill. "We wouldn't be here if we didn't think we could compete with Walgreen," says the CVS regional vice-president.

In less than five years, CVS Corp., based in Woonsocket R.I., has gone from a regional player to a challenger for Walgreen's position as the nation's top drugstore chain. But to get there, it has taken a different route. CEO Thomas M. Ryan has proved a master at growth by acquisition. After snapping up Revco DS Inc. in 1997 and Arbor Drugs Inc. the following year, Ryan more than doubled the CVS store count and geographic base. During the same period, Walgreen CEO L. Daniel Jorndt has proved adept at internal growth, expanding 34% by opening stores on its own. CVS shareholders have been richly rewarded. In the past four years, the stock has risen at a compounded annual growth rate of 30.5%.

But the going is about to get a lot harder. With large acquisition candidates gone, Ryan is now turning to the more expensive strategy of entering new markets by building stores himself. This year, the 4,133-store chain plans to open 65 new outlets--after accounting for store closings and relocations--mostly in new markets such as Chicago and Sunbelt cities in Arizona, Florida, Nevada, and Texas. Even though the chains are running almost neck and neck in sales, with CVS's $20.1 billion last year approaching Walgreen's $21.2 billion, Walgreen has an important advantage: It has already absorbed much of the cost of entering new markets. It has stores in 43 states and Puerto Rico, well ahead of CVS's presence in 34 states.

A GRUDGE MATCH? This raises a key question: Can CVS continue to meet its target for earnings growth of 16% to 18% a year? Recent history suggests not. On June 27, Ryan told analysts to dial back earnings expectations for the second quarter. And although Walgreen posted disappointing third-quarter results, investors have long preferred its prospects to those of CVS. That's one reason CVS stock commands a price-earnings ratio of only 23 vs. Walgreen's 43. Ryan insists CVS will match, and eventually exceed, Walgreen's p-e ratio as it meets expectations. An avid Yankees fan, he treats the contest like an extended grudge match against the Mets. "We are in the fifth inning of a nine-inning game," Ryan says.

The playing field may be the best in retail. Driven by an aging population, blockbuster new drugs, and a rising number of people with prescription insurance coverage, traffic at the neighborhood pharmacy is surging. J.P. Morgan Chase & Co. estimates prescription sales are increasing by 10% a year. "The wind's at our back," Ryan exults.

The two drugstores' star players are alike in many ways: Ryan, 48, and Jorndt, 59, have spent their careers at their chains, starting as pharmacists and rising without business-school training. But the two have pursued starkly different strategies. While Ryan has made bold acquisitions, Jorndt has avoided them because he does not want someone else's real estate mistakes. Ryan moved first into e-commerce with the acquisition of in 1999, but Jorndt waited to develop Walgreen's own Web site. Ryan has also pushed harder into third-party prescription management, and he is alone in directly targeting the specialty pharmacy business, with the chain's ProCare stores. Not yet profitable, those stores cater to customers with acute illnesses, such as AIDS and cancer patients. "That is going to pay off in the future," Ryan says.

BIG BITE. Ryan has executed the strategy flawlessly so far. He integrated the $2.8 billion Revco and $1.5 billion Arbor acquisitions without missing a beat in earnings. That's no mean achievement: Trouble integrating acquired chains is one reason J.C. Penney Co.'s Eckerd Corp. has struggled.

Now, Ryan faces a tougher test. Since its last big acquisition three years ago, CVS has increased its store total by just 11. The chain has closed 293 outlets and opened 304 new ones--mostly in existing markets--since the end of 1998. It has managed to boost sales and profits largely by relocating an additional 529 outlets from smaller stores in strip malls to larger street-corner units, which the company says are 30% more lucrative. But relocations can't drive growth forever. CVS must enter new markets. "There is no other way to grow long term," says Salomon Smith Barney analyst Lisa F. Cartwright.

That puts CVS at a distinct disadvantage. New stores in new markets usually take three or four years to show a profit. And in markets where the two chains are going head to head, the cost of real estate has been surging--by 20% to 30% over the past three years for prime corner sites, according to Daniel B. Hurwitz, executive vice-president at Developers Diversified Realty Corp., which has sold sites to both chains. That's why some analysts doubt Ryan can meet both his earnings and growth goals. Eric Bosshard, an analyst at Midwest Research Co. in Cleveland, contends that "16% to 18% earnings growth isn't achievable while funding new-store growth and continuing the store-relocation program."

Compounding the challenge for CVS: Its existing stores are less productive than Walgreen's. While its growth in prescription sales nearly matches Walgreen's, CVS has lagged in high-margin, "front-end" items, such as cosmetics, seasonal merchandise, and over-the-counter medications. And while Ryan criticizes below-cost promotions at Eckerd, Walgreen has also been turning up the heat. It quietly cut its cosmetics prices by 10% to 20% last month--after earlier reducing prices on skin-care products and vitamins.

Ryan intends to recover ground through better merchandising, a newly rolled-out loyalty card, and expanded cosmetics and photo-processing sections. But those are the least of his problems. While he terms the latest developments just a "temporary setback," CVS already has cut by 27% the number of stores it will add this year and scaled back square-footage growth going forward. Because of a pharmacist shortage, CVS is deferring expansion in some established markets, where new stores pay off the fastest. What's clear is that Ryan is going to need plenty of extra innings to make his plan work.

By Robert Berner in Woonsocket, R.I.

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